Certifications

August 30, 2007

Identifying Experts: Predicting Recessions

A principal theme at "A Dash" is learning how to use expertise. While we write forcefully about what we believe, we also make clear the limitations of the expertise of our team.

Where We Have Strength

The background of our team members is in recognizing the need for experts in various fields to join together to solve problems. My own background includes many projects of this sort. I directed educational programs where scientists, economists, and public policy experts jointly taught seminars on complex policy issues. I worked in government, where economists and political scientists versed in tax policy cooperated in major studies. I have advised and helped to finance early stage companies that involved complex relationships of financing, science, engineering, and business acumen.

My astute colleague, Vince Castelli, directed something called the Innovation Center, a group of civilian workers, cooperating on top-secret projects for the Navy. No single scientific expert could solve the problem.

We learned some important lessons:

Each expert thinks that his/her own knowledge is the most relevant for the problem at hand;

They are all wrong;

It is difficult but rewarding to pull the various themes together to gain true insight.

The result of this experience is that we have strength in figuring out who knows what about various problems. We have special expertise in research methods and seeing what is flawed in approaches that are too narrow.

Predicting Recessions

We do not have a model for predicting a recession, nor do we claim any expertise at such predictions. Our strength lies in distinguishing the real experts from the pretenders. This is more difficult than it might seem, since recessions are an unlikely event, a subject we tried to explain. Anyone trying to predict unlikely events will have many errors. This leads the average observer to believe that there is no expertise involved.

That conclusion is a serious mistake.

Is Everyone an Expert?

CNBC has been posing the recession question to everyone. Is this just a matter of opinion? Is everyone's opinion equal? The way the question is posed carries this implication. It is as if they were asking about American Idol or Dancing with the Stars or what football team will do well this year?

We have noticed a clear trend. The less the responder knows about economics, the more likely the prediction of a recession. Those identified as "Chief Market Strategist" for some company are more likely to be worried and bearish. While economic opinion varies, the economists are more likely to see underlying strength in the economy and view the housing problem as a distribution of cases rather than a stereotype.

Econocator has two good articles (here and here) showing forecasts by economists. One should keep in mind that the average long-term recession expectation is about 20%.

The opinions of CEO's responding to CNBC interviewers and individuals answering polls is important, but not because they are expert forecasters. Their opinions are important because of confidence and investment plans. If everyone's investment and spending plans are governed by media hype on recession, there might be a self-fulfilling prophecy. CNBC today even held discussions speculating on the sad possibility that some hope for this. Watching CEO opinion and consumer confidence is important for this reason.

Bespoke Investment Group provides interesting data from Intrade on prediction market forecasts for a recession. Please note that the market sees a 7% chance of recession this year, defined as two quarter of negative growth. That means that Q307 must turn out to be negative!

The Range of Forecasters

The Bears. At one extreme there are the usual suspects: the long-time bearish market pundits. They cite the "spent-up" consumer, powerful symbolism like the "subslime contagion", and create long causal chains where one domino falls after another. The conclusion, in their view, is inevitable and unavoidable because they, knowing more than the Fed or anyone else, have foreseen this problem. They see the government generally and the Fed in particular as dumber and less informed than they are, concluding that the Fed is "behind the curve."

This viewpoint is argued effectively, vigorously, and repeatedly, getting massive exposure in the media and on the Internet. It has probably had a major effect.

The Error. The problem with these arguments is the arrogance of the approach. It is exactly the opposite of what we recommend. Instead of looking to find expertise, these pundits purport to see something that no one else knows.

In fact, every economist has been well aware of housing problems for years. The question -- still quite open for resolution -- is the extent of the effect on the economy--not stocks or credit markets--but the ultimate economic effect. These pundits argue that economists "do not get it". In fact, professional economists see the same evidence, but reach a different conclusion. Economists have all reduced economic forecasts to reflect housing issues and have done so for years. It is a question of magnitude.

The difference is that those with economic training do not view demand as a single point, but rather as a distribution. They do not see homeowners or lenders or borrowers or workers or employers as a stereotype, but as a distribution of actors.

When a business folds, jobs are lost. The workers do not all move to rocking chairs on the front porch. They seek new employment. Entrepreneurs develop new opportunities. That is why 2.5 million jobs are lost and created in our economy each month. Non-experts have no sense of the dynamism of the economy or the labor market. Astute readers should look for this awareness, and note its absence.

The Real Experts

There are many good economists, but a few days ago on RealMoney we highlighted a CNBC inteview with someone whose organization has the best long-term record on forecasting the business cycle.

Lakshman Achuthan of the Economic Cycle Research Institute was just
interviewed on CNBC. His occasional updates are very important to those
of us interested in economic analysis and forecasting. The ECRI has a
great record that avoids "false positive" recession signals. They use
proprietary leading indicators, but occasionally provide more insight
into what they are seeing. Gary D. Smith also provides periodic updates
on their indicators in his excellent Long/Short Trader column on
RealMoney Silver.

The ECRI is not speaking for a sell-side firm nor trading stocks,
so their comments come without any apparent bias. They sell their
research, and they must deliver a quality product. Today's message? In
answer to a question about the dramatic cover of Fortune, Achuthan made
several interesting comments.

"...the bottom line is that ...dramatic predictions get
attention....(A)lmost every year there is a recession call. In 2002,
2003, 2005, 2006 and now in 2007, we are seeing various scenarios. You
know some speculation and you kind of link it together. There is a
housing crash therefore there must be a recession. Or there is a credit market shock and there must
be a recession. That's not how recessions are made. ...(S)hocks can
help trigger a recession but the economy needs to be vulnerable in the
first place."

Explaining that the ECRI was always looking for vulnerability,
Achuthan continued, "The events we have seen over the last few weeks
and months have taken the shine off of growth out a few quarters, and
we'll get some slowing."

He stated flatly that we would not get a recession this year.
He also pointed out that economic indicators could only look forward a
few quarters. The longest leading indicators show slowing growth, but
he called it "way premature" to forecast a recession.

Asked about a leading indicator he pointed to the spread
between AAA corporates and BAA corporates. Since he thought that
viewers might not believe it, he picked one that you can look up
yourself. "It is a good leading indicator....The spread was about 100
bp's before the credit drama started and now it is actually
smaller...(I)t is a fifteen-month low in the spread."

I like the ECRI's rigorous analysis. It includes long
historical studies to discover the best indicators. It emphasizes
quantification. It shows a clear concept of what leads to recession.
Readers would benefit from looking up the video up on the CNBC site and
taking a few minutes to watch for yourself.

Conclusion

The astute investor must learn to be a wise consumer of information. We tried to highlight this dilemma in an article describing a typical CNBC interview. The comments from our readers were excellent, suggesting many good points and providing new data. After reading the comments, it is quite clear that an articulate advocate, using a stereotype, has a persuasive effect on the intelligent and informed viewer. That is the danger. The anecdotal example, effectively used, has real power--a power to mislead.

Readers should note that this is an article about education and understanding. It is not an immediate bullish market call. While we are bullish from a longer-term perspective, we are quite cautious about current conditions. It is a question of one's time frame. In particular, we are not convinced that the Fed shares the dominant market perspective on interest rate policy. Our technical models remain neutral/negative on the overall market, while still finding many attractive specific sectors.

The single most important takeaway: Beware of those claiming to know more about everything, seeing what no one else sees. A stronger approach is to identify and blend knowledge from true experts.

TrackBack

Comments

This is a very interesting post. Your thoughts make a whole set of sense. I don't see how some people expect Q3 and Q4 to go negative. If that happens I will be absoutely shocked, and if it does, it will have to be caused by some collapse of a scale that has not been seen in years.

Around March, ECRI came out with bullish notes on housing based on their housing price index and featured their construction sector index with their upturn on their webpage. This was right at the top of their own housing price index before it started a fresh downturn, as I recall. I believe that their index construction is still sound, but their interpretation of it may not necessarily portend a secular change.
Also, with regards to their business cycle calls, as their own founder Geoffrey Moore said -- if you can call a recession just as it's starting, you are doing pretty well. They do not call recessions unless the components of their index show pronounced, pervasive and persistent declines. So, a recession forecast is academic from an investment point of view, in my opinion. CXO has a study showing that stock market movements are coincident with the ECRI leading index.

There are some important lessons to be drawn from this post although the implicit point about how only non-economists tend to forecast a recession is not one of them :).

However, I do think you have struck a crucial note by pointing out that what investors, analysts, and essentially economists need today, in order to cope with the amount of information, is a way/method to sort out what is credible information and what is not.

I don't think anyone is saying ECRI is infallible. And they definitely did get their housing call wrong at the beginning of the year. Personally, I think maybe they were out of their element a bit there; however, their business cycle forecasting is still as good as it gets, IMO.

1) Agree that ECRI is the best forecaster out there, and agree that it's because they use a calibrated model looking at lots of data. But they are not infallible. Weren't they calling for a home construction turnaround last January? Or was that just any kind of construction?

2) "The recession question" itself is something of a media hype category. The difference between -0.5% GDP and 0.5% GDP shouldn't mean more to the profits of a random corporation than the difference between 1.5% and 0.5%. But predicting the actual measured GDP, which gets decided in retrospect, and the stock market's take on GDP, which is forward looking, are two very different things.

3) Every day the stock market goes up or down, the media tries to report why it happened, and a lot of the explanations are transparently silly. Recognizing that silliness is a lot easier than saying which top down information is soon to be, but is not yet, priced into the markets (which is what traders care about). Suppose I believe the ECRI is right that growth will slow going forward (they try to predict 9 months out if I remember correctly) but GDP will not go negative in that time window. How should a trader or investor use that idea? Sell far out of the money puts on the index? Be 50% in cash? Figuring that out is a lot harder than just predicting growth is going to slow (which is what one would take away if they were influenced by that CNBC interview your linked, as all three participants were saying that).

4) Marty Whitman has useful names for the contrast between "price conscious" and "outlook conscious" investors. Most of the money traded in the market on a daily basis is more outlook conscious (are things getter better or worse relative to expectations), so predicting that is more valuable. But it is harder to do, so investing primarily in a price conscious way with a nod to the outlook part one can informatively predict - which means modeling the difference between the best predicted outlook and what other market participants will soon think about the outlook - is a sensible strategy.

You make good points, especially in your conclusion. Learning to be a wise consumer, particularly in market trading, and knowing how to evaluate correctly are key to true "experts" and correct knowledge.

This knowing about everything and seeing what no one else sees is a 2 pronged warning. I agree, anyone claiming or alluding to knowing everything is just plain silly, a goal to aspire to but a red warning flag on self promotion. From experience and awareness, because the person is so specialized they can of course see what very few others see in the market they are trading and if their information isn't full of omitted information and other holes they are probably onto something you should listen to.

I like your posts and thought I'd add my 2cents.

If there is interest in really learning Futures Trading we have a seminar class coming up at the CBOE in October which anyone is welcome to check out. Also (smile) a warning this is not your typical futures trading class.

I forgot to add that a moving average crossover would have been just as effective as ECRI's September 2000 warning for something actionable. The decisive call though came in March 2001 which was too late.

Kudos for pointing out the need to understand from where a so-called expert is coming. Everyone has things which tend to bias their views, oftentimes unconsciously. It's like the old saying about how to a hammer everything looks like a nail.

Very interesting ideas about finding the right experts--the proverbial needle in the haystack, especially on cable news. One question for those of us who are beginners at this stuff (or have been away for too long):

Mr. Achuthan cited the, "spread between AAA corporates and BAA corporates..." as one leading indicator for the economy. Can you (or anyone else) explain what exactly he is referencing here and why it is of particular significance?